What is a Fixed Rate Mortgage and a Variable Rate Mortgage?

Are you looking to refinance or buy a new home? If it's your first time buying a property, you need to learn the differences, advantages and disadvantages between a fixed rate mortgage and a variable rate mortgage. Do not expect a definite answer to the question: what is the best mortgage type? The most reasonable response anyone can give is: it depends. The type of home loan you choose depends on your specific personal and financial circumstances. When it comes to the type of mortgage that best suits your needs, it is important to think about your financial situation, predict possible life changes, and determine how quickly you want to pay off your loan.

A fixed-rate mortgage allows you to borrow a certain amount of money (principle) and pay back the principle plus a fixed amount for borrowing the money (interest) incrementally over a period of time. With a fixed rate mortgage, the interest rate is locked for the duration of each term. At the beginning of each term, the interest rate is locked to the market interest rate until the end of the term. For example, if you obtain a 25-year amortization fixed rate mortgage with 5 year terms, your interest rate may be subject to change/renew every 5 years. For the entire duration of each term, your mortgage payments will not be affected by the fluctuations on the market interest rates. Monthly payments only change if paying for other things like insurance and taxes, which can fluctuate with time. The lender assumes the risk for changes in interest rates.

In a variable rate mortgage, the interest that you pay with your mortgage payments will be affected by market interest rate fluctuations. The interest rate on a variable-rate mortgage is usually less than that of a fixed-rate mortgage, leading to less expensive initial payments; however, borrowers may end up paying more long-term as interest rates often increase. Essentially, the risk in interest rate changes is shifted from lenders to borrowers.

According to the Bank of Montreal (BMO Canada), approximately 70% of the homeowners have chosen fixed rate, and 30% of the homeowners have chosen variable rate. So generally speaking, people tend to go for fixed rate mortgage.

Advantages and disadvantages of fixed rate mortgage

You have better control over your mortgage payments - The main advantage of a fixed-rate mortgage is consistent, predictable costs long-term. Because your rate is locked for the duration of each term, the amount of interest you pay will not be affected by market interest rate changes, which makes this option more attractive from a budgeting standpoint. However, a fixed rate mortgage often starts with higher initial costs with higher starting APR.

You have better control over your amortization length - Because you have better control over the amount of principal and interest you pay in your mortgage payments, you generally have a better idea on approximately when you can pay off your mortgage.

Market interest rate can act like a double-edge sword - While your interest rate is locked, if the market rate goes up, you'd be saving money on interest. But if the market rate goes down, you'd be paying more on interest compared with people with variable rate mortgages.

Minimize financial risks - The main reason why people choose fixed rate mortgage is to minimize financial risks. If you don't feel comfortable predicting market trends, you will feel more emotionally and financially secure knowing exactly how much you pay in principal and interest in your mortgage payments by choosing a fixed rate mortgage. You minimize the risks of the impact from market interest rate changes on your mortgage payments.

Harder to get approved - Financial institutions usually require you to have good credit score to set you up with a fixed rate mortgage.

Advantages and disadvantages of variable rate mortgage

If you are confident that the market interest rate is going to drop over time for the foreseeable future, you can choose to go with a variable rate mortgage. When the market interest rate drops, you will be paying more towards to the principal of your mortgage with your mortgage payments. As a result, you will be paying off your mortgage faster than with a fixed rate mortgage.

However, if the market interest rate goes up, you will be paying more towards interest and less towards to the principal of your mortgage with your mortgage payments. As a result, you will be paying off your mortgage slower than with a fixed rate mortgage. This is the primary disadvantage of a variable rate mortgage - unpredictable rates. In many cases, the portion of payment dedicated to interest can change with variations in the prime rate. In some cases, the entire monthly mortgage payment can fluctuate itself. A major increase in the prime rate can cause the interest a borrower owes to increase, which could place a strain on a household's budget.

In short, in the economy where the market interest rate is rising, people with fixed rate mortgage will benefit from paying less on interest in their mortgage payments because their interest rate is locked to a lower rate. In the economy where the market interest rate is dropping, people with variable rate mortgage will benefit from paying less on interest in their mortgage payments because their interest rate follows the market interest rate.

A variable rate mortgage usually starts with lower interest rate (APR). For example, with RBC Royal Bank of Canada, a fixed rate mortgage with 5-year term may start with 3.40% interest rate, while a variable rate mortgage with 5-year term may start with only 3.20% interest rate.

Differences between Open, Closed, and Convertible mortgages

An open mortgage allows you to submit payments directly to the principal of your mortgage loan in part or in full anytime without incurring prepayment charges. An open mortgage usually start with higher interest rates as the financial institutions need to profit from charging interest as much as possible. Borrowers aren't locked into their loans and are able to make payments ahead of schedule. The key distinction of an open rate mortgage is the ability to pay off a loan early without penalties.

A closed mortgage allows you to prepay up to a certain percentage of the original mortgage amount - usually 20 percent. Any further prepayment is subject to applicable charges and penalties. Closed mortgages are restrictive mortgages with limited flexibility. While closed mortgages carry lower interest rates, borrowers are discouraged from paying their loans off early without incurring penalties. Closed mortgages lack the ability to fully pay off the loan until the end of the term. Additionally, if you have a closed mortgage, prepayment costs apply if you request loan refinancing or rescheduling.

A convertible mortgage often allows you to prepay up to a certain percentage of the original mortgage amount annually - usually 10 percent - without attracting prepayment charges and penalties.

Should I go for fixed rate mortgage or variable rate mortgage?

Choosing fixed rate or variable rate will have an impact on the amount of interest you pay in your mortgage payments, and ultimately impact how quickly you can pay off your mortgage.

Keep in mind that even if you go for a 25-year amortization mortgage, you have the flexibility to renew the terms as they are due for renewal. For example, if you are on a 5-year term, if you feel that in the next 5 years, the market interest rate will go up, then choose fixed rate for the next 5 years to protect yourself from paying more on interest due to market fluctuations. After 5 years, you can then re-evaluate and choose variable rate if you feel the market interest rate will drop for the next 5 years.

People generally are not comfortable predicting the market trends. This is why the majority of home buyers tend to choose fixed rate rather than variable rate. So if you are not comfortable taking on the risks of market interest rate fluctuations, go for fixed rate.

The truth is, you can often pay off your mortgage faster by having a convertible mortgage and paying a lump sum towards the principal of your mortgage loan every year. Some financial institutions also allow you to "double up" your mortgage payments and pay directly to the principal of your mortgage loan.

There are many other ways that can help you pay off your mortgage faster. Don't burden yourself too much on choosing between fixed or variable rate.